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Wal-Mart Stores, Inc. Has Dollar Stores in Its Crosshairs

Wal-Mart Stores, Inc. is preparing an onslaught that could cause big trouble for dollar stores in the next 10 years.

Following a weak performance in its recently ended 2014 fiscal year, Wal-Mart Stores(NYSE:WMT) is looking to regroup this year. The company's top goal going forward must be to reinvigorate sales growth in the U.S., which is by far its largest market. Last year, sales for the Walmart U.S. division grew just 1.8%.

To boost sales in the U.S., Wal-Mart will rely increasingly on growing its fleet of small-format Walmart Neighborhood Market and Walmart Express stores. By doing so, Wal-Mart will start to challenge the three big dollar store chains: Family Dollar(UNKNOWN:FDO.DL), Dollar General(NYSE:DG), and Dollar Tree(NASDAQ:DLTR).

Wal-Mart is moving away from its reliance on giant Supercenters like this one.

In 2014, Wal-Mart's small-format growth initiatives will have little impact on either Wal-Mart or its dollar store competitors. However, if these initiatives deliver good results in the next year or two, Wal-Mart has the resources to ramp up spending and rapidly add new stores. That could cause big problems for all three dollar store chains.

Going small in the U.S.Wal-Mart has found that customers do not want to navigate giant Walmart Supercenters every time they need a few grocery items in the middle of the week. As a result, the company's small-format stores have been more successful recently.

These come in two flavors. "Walmart Neighborhood Markets" average 38,000 square feet and are meant to cater toward "basic food trips." "Walmart Express" stores are just 15,000 square feet on average and carry convenience items and fresh foods. Many of these include pharmacy counters and/or gas stations.

Accordingly, Wal-Mart announced last week that it intends to make a big push to add small-format stores. Whereas the company had previously planned to open 120 to 150 of these stores in the new 2015 fiscal year, now it intends to open 270 to 300, which will nearly double its small-format store count.

Threatening the dollar storesWal-Mart's small-format stores compete with a variety of other retailers, including supermarkets and drugstores. However, their closest competitors in terms of product assortment and customer base are the dollar stores. Just last week, retail analyst Michael Exstein suggested that Wal-Mart should try to buy one of the dollar store chains -- preferably Family Dollar -- to enter that market faster.

If Wal-Mart were to follow that strategy to add more small-format stores, it would be great news for shareholders of whichever chain it decided to acquire. However, while a deal is still possible, Wal-Mart's management has indicated that it prefers to go it alone. Wal-Mart is interested in offering fresh foods, gasoline, and pharmacy services in many of its small-format stores, and the dollar stores are not set up well for these things.

All of the dollar stores are massive national chains: Dollar General has around 11,000 stores, Family Dollar has 7,900, and Dollar Tree has nearly 5,000. As such, Wal-Mart's decision to open an extra 150 small-format stores next year will not have a significant impact on their financial results.

The longer-term implications are more worrisome. Adding 150 extra small-format stores to its fiscal year 2015 capital plan increased the Walmart U.S. capital budget from a $5.8 billion-$6.3 billion range to a $6.4 billion-$6.9 billion range.

Thus, it will cost around $600 million to add the extra 150 stores -- less than 10% of the company's domestic capital budget. In other words, if Wal-Mart decides to keep emphasizing smaller stores, it has the financial resources to grow incredibly quickly.

A new risk factorThe dollar stores have carved out a profitable niche for themselves by appealing to low-income customers while offering more convenience than Wal-Mart. However, Wal-Mart's small-format stores could become a big challenger to the dollar stores if the company continues to aggressively add locations.

It's too early to count the dollar stores out, but competing with Wal-Mart won't be easy. Wal-Mart has the most efficient supply chain in retail, and this will give it a critical cost advantage. As a result, I'd be more inclined to bet on Wal-Mart than on the dollar stores in this fight.

Author

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry! Follow @AdamLLW